Modeling the Dynamics of Financial Dollarization under Structural Shifts in Latin America: The New Fourier Panel ARDL Approach

Abstract

This study investigates the determinants and dynamic structure of financial dollarization in thirteen Latin American countries from 2004 to 2023, namely Argentina, Chile, Mexico, Guatemala, Paraguay, Costa Rica, Uruguay, Bolivia, the Dominican Republic, Honduras, Nicaragua, Trinidad and Tobago, and Peru. Although dollarization remains persistent across the region, empirical research addressing its nonlinear nature and structural break dynamics is still limited. To fill this gap, the study applies Fourier Panel ARDL together with Fourier Panel KPSS tests to financial dollarization analysis for the first time in the literature, offering an innovative framework that captures smooth regime transitions through frequency-based structural components. Preliminary tests reveal strong cross-sectional dependence and slope heterogeneity, confirming the relevance of second-generation panel methods. The CIPS and Fourier KPSS tests show that all variables are integrated of order one, while both Pedroni and Westerlund cointegration tests provide strong evidence of a stable long run relationship among them. Long-run estimates from the Fourier Panel ARDL model indicate that financial development reduces dollarization, whereas inflation, interest rate differentials, and exchange rate depreciation increase it. In the short run only the exchange rate is statistically significant, and the negative and significant ECM coefficient reflects a strong adjustment mechanism toward long-run equilibrium. Moreover, the Dumitrescu and Hurlin panel causality test identifies one-way causality from financial development to financial dollarization and two-way causality between inflation and dollarization and between the exchange rate and dollarization, demonstrating that dollarization evolves through interactive interest rate and exchange rate channels. By introducing Fourier-based panel methods into the analysis of Latin American dollarization for the first time, the study provides original methodological and empirical contributions to the existing literature.